Financial ratios- hand outs

Gross margin, Gross profit margin or Gross Profit Rate can be defined as the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to cover overheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross profit and sales revenue.
It can be expressed in absolute terms::
Gross Profit = Revenue − Cost of Goods Sold
or as the ratio of gross profit to sales revenue, usually in the form of a percentage:
Cost of goods sold includes variable and fixed costs directly linked to the product, such as material and labor. It does not include indirect fixed costs like office expenses, rent, administrative costs, etc.
Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income. For a retailer it will be their markup over wholesale.
Larger gross margins are generally good for companies, with the exception of discount retailers. They need to show that operations efficiency and financing allows them to operate with tiny margins.

In business, operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS) is the ratio of operating income (operating profit in the UK) divided by net sales, usually presented in percent.

Profit margin, Net Margin, Net profit margin or Net Profit Ratio all refer to a measure of profitability. It is calculated using a formula and written as a percentage or a number.
The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses' operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure, so that comparison of one with another can have little meaning. A low profit margin indicates a low margin of safety: higher risk that a decline in sales will erase profits and result in a net loss.
For example, a company produces a loaf of bread and sells it for 10 units of currency. It cost the company 6 units of currency to produce the bread and it also had to pay an additional 2 units of currency in tax.
That makes the company's net income 2 units of currency (10 - 6, before tax, then minus 2 for tax). Since its revenue is 10 units of currency, the profit margin would be (2 / 10) or 20%.
Profit margin is an indicator of a company's pricing policies and its ability to control costs. Differences in competitive strategy and product mix cause the profit margin to vary among different companies.
Return on Equity (ROE, Return on average common equity, return on net worth) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.
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But not all high-ROE companies make good investments. Some industries have high ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are better investments than refiners just because of their ROE. Generally, capital-intensive businesses have high barriers to entry, which limit competition. But high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. As with many financial ratios, ROE is best used to compare companies in the same industry.
High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate.
ROE is presumably irrelevant if the earnings are not reinvested.
The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).
New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"
Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always recalculate on a 'per share' basis, i.e., earnings per share/book value per share.

In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment. ROI is usually expressed as a percentage rather than decimal value.
ROI does not indicate how long an investment is held. However, ROI is most often stated as an annual or annualized rate of return, and it is most often stated for a calendar or fiscal year. In this article, "ROI" indicates an annual or annualized rate of return, unless otherwise noted.
ROI is used to compare returns on investments where the money gained or lost — or the money invested — are not easily compared using monetary values. For instance, a $1,000 investment that earns $50 in interest generates more cash than a $100 investment that earns $20 in interest, but the $100 investment earns a higher return on investment.
$50/$1,000 = 5% ROI
$20/$100 = 20% ROI
When considering a continuous process of gaining or losing money with a constant rate of return, the annual rate of return is any value greater than -100%; a positive percentage corresponds to exponential growth of the capital, a value between -100% and 0% exponential decay.

Asset turnover is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company.[1]
"Sales" is the value of "Net Sales" or "Sales" from the company's income statement
"Average Total Assets" is the value of "Total assets" from the company's balance sheet in the beginning and the end of the fiscal period divided by 2.

The Return on Assets (ROA) percentage shows how profitable a company's assets are in generating revenue.
ROA can be computed as:
This number tells you "what the company can do with what it's got", i.e. how many dollars of earnings they derive from each dollar of assets they control. It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets.[1]
Contents
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1 Usage
2 References
3 See also
4 External links
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[edit] Usage
Return on assets is an indicator of how profitable a company is before leverage, and is compared with companies in the same industry. Since the figure for total assets of the company depends on the carrying value of the assets, some caution is required for companies whose carrying value may not correspond to the actual market value. Return on assets is a common figure used for comparing performance of financial institutions (such as banks), because the majority of their assets will have a carrying value that is close to their actual market value. Return on assets is not useful for comparisons between industries because of factors of scale and peculiar capital requirements (such as reserve requirements in the insurance and banking industries).

Return on Assets Du Pont is a financial ratio that shows how the return on assets depends on both asset turnover and profit margin. The Du Pont method breaks out these two components from the return on assets ratio in order to determine the impact of each on the profitability of the company.
Return on assets Du Pont can be expressed as:
ROA Du Pont = (Net income / Sales) x (Sales / Total Assets)
This ratio helps to highlight the impact of changes in asset turnover and profit margin.[1]

Return on net assets
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(abbreviated to RONA) Profit after tax / ( Fixed assets + working capital )
It is a measure of financial performance of a company which takes the use of assets into account.

Return on invested capital (ROIC) is a financial measure that quantifies how well a company generates cash flow relative to the capital it has invested in its business. It is defined as Net operating profit less adjusted taxes divided by Invested Capital and is usually expressed as a percentage. In this calculation, capital invested includes all monetary capital invested: long-term debt, common and preferred shares.
When the return on capital is greater than the cost of capital (usually measured as the weighted average cost of capital), the company is creating value; when it is less than the cost of capital, value is destroyed.
[edit] Basic formula
ROIC = (Net Operating Profit − Taxes)/(Total Capital)
Note that the numerator in the ROC fraction does not subtract interest expense, because demoninator includes debt capital.


Accounting liquidity (liquidity) is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities.
Contents
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1 Calculating liquidity
2 Understanding the ratios
3 Liquidity in banking
4 See also
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[edit] Calculating liquidity
For a corporation with a published balance sheet there are various ratios used to calculate a measure of liquidity. These include the following:
the current ratio, which is the simplest measure and is calculated by dividing the total current assets by the total current liabilities. A value of over * the quick ratio - calculated by deducting inventories and prepayments from current assets and then dividing by current liabilities - gives a measure of the ability to meet current liabilities from assets that can be readily sold. A better way for a trading corporation to meet liabilities is from cash flows, rather than through asset sales, so;
the operating cash flow ratio can be calculated by dividing the operating cash flow by current liabilities. This indicates the ability to service current debt from current income, rather than through asset sales.
[edit] Understanding the ratios
For different industries and differing legal systems the use of differing ratios and results would be appropriate. For example, in a country with a legal system that gives a slow or uncertain result a higher level of liquidity would be appropriate to cover the uncertainty related to the valuation of assets. A manufacturer with stable cash flows may find a lower quick ratio appropriate than an Internet-based start up corporation.
[edit] Liquidity in banking
Liquidity is a prime concern in a banking environment and a shortage of liquidity has often been a trigger for bank failures. Holding assets in a highly liquid form tends to reduce the income from that asset (cash, for example, is the most liquid asset of all but pays no interest) so banks will try to reduce liquid assets as far as possible. However, a bank without sufficient liquidity to meet the demands of their depositors risks experiencing a bank run. The result is that most banks now try to forecast their liquidity requirements and maintain emergency standby credit lines at other banks. Banking regulators also view liquidity as a major concern.

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm's current assets to its current liabilities. It is expressed as follows:
For example, if WXY Company's current assets are $50,000,000 and its current liabilities are $40,000,000, then its current ratio would be $50,000,000 divided by $40,000,000, which equals 1.25. It means that for every dollar the company owes it has $1.25 available in current assets. A current ratio of assets to liabilities of 2:1 is usually considered to be acceptable (ie., your assets are twice your liabilities).[1]
The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry. If a company's current assets are in this range, then it is generally considered to have good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets.

In finance, the Acid-test or quick ratio or liquid ratio measures the ability of a company to use its near cash or quick assets to immediately extinguish or retire its current liabilities. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. Such items are cash, cash equivalents such as marketable securities, and some accounts receivable. This ratio indicates a firm's capacity to maintain operations as usual with current cash or near cash reserves in bad periods. As such, this ratio implies a liquidation approach and does not recognize the revolving nature of current assets and liabilities. The ratio compares a company's cash and short-term investments to the financial liabilities the company is expected to incur within a year's time.
OR
Generally, the acid test ratio should be 1:1 or better, however this varies widely by industry. [1]
Receivable Turnover Ratio is one of the Accounting Liquidity ratios, a financial ratio. This ratio measures the number of times, on average, receivables (e.g. Accounts Receivable) are collected during the period. A popular variant of the receivables turnover ratio is to convert it into an Average Collection Period in terms of days. Remember that the Receivable turnover ratio is figured as "turnover times" and the Average collection period is in "days".
Inventory turnover ratio is one of the Accounting Liquidity ratios, a financial ratio. This ratio measures the number of times, on average, the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. A popular variant of the Inventory turnover ratio is to convert it into an average days to sell the inventory in terms of days. Remember that the Inventory turnover ratio is figured as "turnover times" and the average days to sell the inventory is in "days".
Inventory turnover ratio = Cost of goods sold / Average inventory[1]
Average days to sell the inventory = 365 / Inventory Turnover Ratio[2]